Big Banks Deciding The Fates Of Troubled Subprime Lenders
(Market Watch) -- A credit crunch in the market for low-end
mortgages has left companies specializing in these subprime
loans at the mercy of big banks like Merrill Lynch & Co. and
J.P. Morgan Chase.
subprime lenders, such as Ownit Mortgage Solutions, Mortgage
Lenders Network USA and ResMAE Mortgage Corp., have already
filed for bankruptcy protection after having financial
lifelines cut by Merrill and other big banks.
The fate of
other publicly traded subprime specialists, such as New
Century, Novastar Financial and Fieldstone Investment, may
also rest in the hands of big banks that have helped finance
their recent rapid expansion, analysts said.
mortgages are offered to homebuyers who fail to meet the
strictest lending standards. While these loans remain a small
part of the home lending industry, they've helped more people
buy homes who previously couldn't afford it, helping to fuel a
surge in housing prices in 2004 and 2005.
That's why the
credit crunch in the subprime market is being so closely
watched by investors, economists and policymakers. By cutting
off access to credit for these extra buyers, demand for homes
may fall further, depressing prices and fueling a broader
slowdown in the U.S. housing market.
in the subprime area is a significant concern," Ben Bernanke
said on Wednesday. While noting that the contraction has yet
to reach a point where it will affect overall economic
expansion, the Federal Reserve chairman said he's monitoring
"There are some
loans that have been made that are not turning out well, and
to the detriment of both the lenders and the borrowers," he
said. "We will certainly be watching that carefully and trying
to provide guidance and oversight to minimize that risk going
specialists sell the loans they've originated to big banks,
which then package them up and sell them on again as
mortgage-backed securities to hedge funds and other
It usually takes
at least several weeks for subprime specialists to sell their
loans. During that time, big banks provide a "warehouse" in
which to store them. In return for passing the loan onto these
warehouse lenders, the originators get cash equal to the value
of the asset, minus a fee, called a "haircut", which provides
a cushion against late payments and delinquencies.
banks, such as Merrill. J.P. Morgan Chase, Citigroup and Bank
of America, are crucial to this process because they keep
subprime lenders supplied with enough cash to help them make
more loans immediately.
But as more
subprime borrowers struggle to meet their monthly mortgage
payments, cracks have begun to form in this system.
lenders have started worrying about the quality of subprime
loans that have been originated in recent years. Some are now
asking subprime specialists for bigger haircuts, putting the
originators in financial peril and forcing some into
lenders are the lifelines for a lot of these subprime
originators because they don't have the financial capacity to
fund these loans by themselves," Ernie Napier, head of the
specialty finance team at rating agency Standard & Poor's,
said. "To the extent that these warehouse lenders go away, the
whole process starts to unravel."
Network USA, the 15th largest subprime company in the U.S.,
filed for bankruptcy protection this month.
borrowers defaulted early on the company's loans at the end of
2006, it tightened lending standards. It also introduced a new
product, but mispriced it. After making at least $600 million
in new loans with this product, Mortgage Lenders Network had
to sell them at a loss in the secondary market.
Some of the
company's warehouse lenders, which included Merrill and
Goldman Sachs, cut back their financing, forcing Mortgage
Lenders Network to post more collateral. When it couldn't come
up with the extra cash, some of these lenders refused to
advance any more money and the company had to shut down,
according to its bankruptcy filing.
was that the warehouse lenders put them up against the wall
and then pulled the plug," S&P's Napier said.
Ownit, one of
the fastest growing subprime originators which was partly
owned by Merrill, filed for bankruptcy on Dec. 28.
J.P. Morgan Chase, which had provided warehouse financing
since late 2003, said it planned to shut down the facility by
the middle of December. Merrill then made a margin call,
sweeping up about $15 million of the company's cash, leaving
it with roughly $7.4 million in liquid funds, according to
month, J.P. Morgan Chase decided not to fund loans Ownit had
recently made and froze the rest of its money, Ownit said. By
Dec. 5, Ownit said it had to lay off most of its employees.
In recent weeks,
warnings from banking giant HSBC Holdings and New Century have
shaken subprime confidence further, sparking speculation that
a major bank is aggressively making margin calls.
Lenders has had to come up with more cash after getting margin
calls from some of its warehouse lenders, Stuart Marvin,
executive vice president at the subprime specialist told
analysts during a conference call on Wednesday. See story on
Accredited's recent results.
"We have eight
different warehouse lenders; I would say the majority of them
are acting very rationally," Marvin said. "There is one that
is acting somewhat irrationally, although I won't mention them
by name. We have migrated the fundings away from that
warehouse lender to one of the other seven until they begin to
act more rationally again."
publication National Mortgage News said this week that Merrill
Lynch has been making margins calls. A Merrill spokesman
declined to comment.
In late January,
J.P. Morgan Chief Executive Jamie Dimon noted rising defaults
in some of its riskiest home loans and said the bank had
largely exited the subprime business. See full story.
Big banks are
clamping down on subprime specialists in other ways too.
sell loans on to big banks, the buyers have the right to send
them back in certain circumstances, including when borrowers
fail to make payments during the first month or two. In those
cases, the originator is forced to repurchase the loans.
defaults have jumped for subprime loans made in recent years,
forcing higher-than-expected repurchases by originators like
New Century, Fremont and Accredited.
can threaten the survival of subprime originators because they
can struggle to come up with the extra cash needed to buy the
Corp., which had quickly become the 20th largest subprime
specialist in the U.S., filed for bankruptcy this week and
said it plans to sell most of its assets to Credit Suisse for
$19 million. See full story.
By early 2005,
loan originations began to wane, knocking ResMAE's
profitability. By cutting costs and lifting the interest rates
it charged on loans, the company said it was able to make a
small profit last year "despite the industry collapsing around
But then Merrill
Lynch, which had become the largest buyer of ResMAE's loans,
asked the company to repurchase more than $300 million worth
of loans. That "enormous" repurchase request, which ResMAE
disputes, triggered a liquidity crisis and forced the company
to put itself up for sale.
demands "crippled ResMAE's operations by requiring the company
to post enormous reserves, which dramatically reduced its
capital and operating liquidity," the company said in its
New Century shares
lost more than a third of their value last week after the
mortgage services provider slashed its forecast for loan
production this year because early-payment defaults and loan
repurchases have led to tighter underwriting guidelines. See
The company said
it has to restate most of its results from 2006 because of
mistakes in how it accounted for losses on repurchased loans.
New Century got
into trouble because its systems didn't predict the level of
repurchases accurately enough, said Zack Gast, a financial
sector analyst at the Center for Financial Research and
Analysis (CFRA), a research firm.
The company was
particularly aggressive in how it accounted for the cost of
buying back loans, Gast explained.
approach is to set aside money based on the assumption that if
forced to repurchase problem loans, originators will likely
have to resell again them at a lower price, Gast said.
Century only provisioned for the cost of repurchasing the
loans. Once those assets were back on its balance sheet, the
company recorded 100% of their value, Gast noted.
"The pool of
loans sitting on their balance sheet has been valued at the
wrong price," he concluded.
that go out of business usually do so because of a lack of
liquidity," Bruce reminded his clients ominously.
New Century has
financing agreements with lots of large banks including Bear
Stearns, Citigroup, Credit Suisse, Deutsche Bank, Morgan
Stanley, UBS AG and Goldman.
include covenants requiring New Century to maintain minimum
levels of liquidity and debt levels. If those are breached,
the lenders can terminate the agreements and demand their
money back immediately.
New Century is
currently required to keep liquidity levels to at least $134.4
million, according to its latest quarterly results filing with
the Securities and Exchange Commission. The company said last
week that it had cash and liquidity in excess of $350 million
at the end of 2006.
After the warnings
from New Century and HSBC, warehouse lenders are probably now
deciding which subprime originators to continue backing and
which ones to drop, CFRA's Gast said.
"If all lenders
increase their margin requirements that would probably result
in bankruptcy," he said. "If you can't come up with the extra
cash, then the warehouse lenders will step in and shut you
But which other
subprime specialists are in peril?
Gast said that
depends partly on companies' liquidity and how aggressive
they've been in accounting for repurchased loans.
"In the current
liquidity environment, CFRA does not believe any lender is at
low risk," he wrote. "All lenders are showing signs of credit
Gast was also
reluctant to say whether things will get worse for the
subprime industry, or estimate when the situation might
improve. However, other experts are concerned about the
While most of
Accredited's warehouse lenders have remained rational, Marvin
suggested these big banks could take a tougher approach to
rival subprime specialists with less liquidity.
long-awaited meltdown in subprime mortgage lending is now
underway, and it likely has further to go," Richard Berner,
chief U.S. economist at Morgan Stanley, wrote in a note to
clients this week. "More subprime lenders may fold, and the
supply of subprime credit likely will tighten further."
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